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I speak the truth not so much as I would, but as much as I dare:and I dare a little more as I grow older.
-- Michel de Montaigne (influential writer of the French Renaissance)

This Friday finds me sleeping later than I planned … in the lounge at the airport in Stockholm, on my way to Paris. To the great applause of readers all over the world this may be the shortest letter in 12 years. I will write here and on the plane and quit when I land so I can be with friends this evening. No time for exhaustive research, so we will march through random topics that caught my attention this week until it is time to hit the send button. In no particular order, let's jump in.

Sweden, the Socialist Mecca

I was brought to Stockholm to speak for Swedbank. They arranged for me to meet a wide variety of local people, as well as to have dinner with readers. I talked with a number of people who were in positions of authority during the Swedish credit and debt crisis of the early 1990s. And a crisis it was. The currency was under attack, as the fundamentals were negative. This was at the same time that George Soros was attacking the British pound. Interest rates had been rising in Sweden, but the financial environment was being loosened. This meant that Swedish businesses and consumers could borrow in foreign currencies that had much lower interest rates, and borrow they did. The central bank made it very clear that they would protect the value of the currency, and everyone believed them. Remember, this is a relatively small country, and basically everyone knows someone who at least knows someone who was involved with the central bank. The central bank was adamant in its belief that it could protect the value of the currency, and it raised rates by 500% in order to do so.

Why such a fetish for a strong currency in a country that was driven by exports? Because their past experience had dictated that not defending the currency was the wrong thing to do. My guests went into detail about Swedish history (which I found fascinating), explaining the thought process at the time. Just as hyperinflation in the 1920s had scarred Weimar Republic Germany, leaving that nation with a visceral reaction to loose monetary policy, the history of Sweden had colored Swedish views as to appropriate monetary actions.

That seems to me the classic problem of generals always fighting the last war in their planning," I said. "Precisely," came back the quick answer. To even mention publicly that "maybe we should allow the currency to float or weaken" invited late-night phone calls from the leadership, raising the question of the individual's future participation in polite circles.

Ultimately, of course, the market dictated that the currency could not be kept at artificially high rates in either Sweden or Great Britain. The Exchange Rate Mechanism broke down. The Swedish Krona was allowed to float and overnight dropped 21%. Which meant that the incomes produced in Sweden to pay the interest on foreign loans dropped 21% in relationship to interest-rate costs. Property was immediately less valuable in terms of the currency that had been borrowed to pay for it.

Unemployment soared as a recession hit. The government deficit rose overnight to 10%, as there were less tax revenue and higher unemployment costs. Government debt rose, and the bond market wanted higher interest rates, which of course made the situation worse.

"Let me guess. Most of the larger businesses and investors saw the crisis coming and protected themselves. The smaller people and businesses were hurt the most." My hosts (who, even though younger than I, were at that time were already in responsible positions) had all lived and suffered through those times. And they all smiled and nodded yes. Well, they remembered, as they talked among themselves, that there was one large company that believed the central bank up until the end, and it went bankrupt.

What the US Needs Is a Good Swedish Socialist

Interestingly, no matter the politics of the persons I talked with, there was universal disagreement (if not disdain) with how the US had handled its recent banking crisis.

"We did it much differently and it proved to be the right way. If a bank wanted government help, the government said 'Sure. No Problem. Just give us all your private equity.' Shareholders were wiped out in exchange for government help."

They recalled that bankers did everything they could not to fall into the gentle hands of the government. But if they did, the government took the assets and put them into a good-bank and a bad-bank pile. Typically, the assets that were under water were real estate-related. As an aside, as the government sold the assets after some time and ended up not losing on their real estate portfolio, which shows the value of being patient money in the middle of a crisis.

If we had only had Swedish socialists running our TARP program.

And speaking of Swedish socialists, if someone tried to introduce their "solution" to the Swedish equivalent of our Social Security program in the US, there would be weeping and wailing and gnashing of teeth in both parties. It would be deemed the end of the world and heartless cruelty.

Sweden's system is set up as a "pay as you go" model of social security. What current retirees get is a direct function of what current employees pay. If during a recession the revenue goes down, then the social security payments go down. You can actually have a case where your retirement pension goes down within a given year rather than up, if the country is in recession. In essence, their social security costs are indexed to GDP. They can never run a deficit in the program. I suppose they could raise the tax, but there seems to be little appetite for raising taxes.

There was some clear chafing at being labeled a socialist nation, which most of us in the US think they are. "We could teach you a lot about being responsible socialists" was the universal response. "In many ways, we are less socialist than you."

Going back to the crisis, many remembered reading a report from a major European group, talking about how Sweden was doomed to years of depression and endless malaise. Yet within a few years Sweden was again growing, as those socialists got their government act together, and the country has never looked back. From a very large debt-to-GDP (I can't recall the exact number, but was indeed large [and there is no internet on Air France]), it is now between 30 and 40%, much more like that of an emerging-market nation. It helped their recovery that they had a strong export sector, which was aided by a drop in their currency valuation. They now run surpluses everywhere, and their currency floats.

While Europe went into a recession with the credit crisis and is once again rolling into recession, Sweden has grown, albeit slowly.

"Europe Short of Magic Wands"

That was the headline in the European version of the Wall Street Journal. The front-page headline was "Data Suggest More Woes In Euro Zone." The Purchasing Managers' Index was down, against expectations.

"At a minimum, some analysts said, the recessionary signals make it appear that ECB officials were overly optimistic in recent statements that the euro bloc is on track for recovery and the central bank can start discussing ways to unwind its crisis measure. 'The euro zone is far from out of the woods' said Howard Archer of HIS Global Insight." (Wall Street Journal)

That is hardly a surprise. Italy is projected to contract at 1.3% this year. Spain is in recession. Germany and France are barely growing. Spanish interest rates are rising in spite of ECB action, with Spanish rates now above those of Italy.

Spain has been a major topic of discussion here in Stockholm. The conference I spoke at was attended mostly by large asset managers, both fixed-income and equities. Some rather savvy managers were openly wondering how Spain could solve its current woes.

The country is in recession. Unemployment is 20% and 50% among youth. The deficit is now projected to be 5.8%, up from the target the previous government agreed to. The EU is not happy with the new Spanish government, which signed the new fiscal agreements only to turn around in a few days and increase its projected deficits.

How can Spain enter into anything approaching a Greek-like austerity program? Its private sector debt is over 200% of GDP, and they are being forced to deleverage. If the public sector attempts to do so, it will make GDP much worse in the short term, which will increase unemployment. Spanish Prime Minister Mariano Rojay is in a no-win situation. If he cuts the deficit too much, he risks a deeper recession and a corresponding decrease in tax revenues (and rising unemployment costs), which of course makes the deficit worse. For an example, look to Greece to see how well such policies work.

But if he tells the EU to forget their deficit targets, he risks not merely their ire, which he can deal with, but the possibility that they demand a more austere budget in return for assistance.

One of my hosts suggested that Rajoy is in control and can do what he wants. I disagreed, noting that he is in a serious game of poker. He only has access to the bond market at rates that are even close to being sustainable as long as the ECB is buying Spanish debt and funding
Spanish banks, which are buying Spanish debt with complete abandon. Spanish banks raised their holdings of Spanish government debt by more than 10% in both December and January, a larger increase than for any other banks in the various nations of the eurozone. There is no reason to think that trend did not continue in February and this month.

Rajoy has pushed all of his chips toward the middle of the table in a gamble that the rest of the euro zone, and most notably Germany, will not really try and force Spain to take serious deficit reduction measures too quickly. "How can they force them?" I was asked.

"Very simply. They simply tell the ECB not to fund Spanish debt below a certain level of interest rates. Indeed, the recent interest-rate rise, well above that of similarly beleaguered Italy, may be more than a coincidence. It may be a less than subtle reminder to Rajoy as to who is in real control. Without ECB help, Spanish bond rates start to look like Greece's, and the end quickly approaches. The only options at that point are default and/or leaving the eurozone."

Which is of course the hand that Rajoy is holding. "Push me too far and let's see how you like a real banking crisis," as the "D" word (default) enters the Spanish vocabulary. THAT would create huge headaches and sleepless nights in capitols all over Europe. Rajoy is betting that Merkel will blink. While Europe can afford to lose Greece and even poor little Portugal (although there is a great deal of nostalgia and sentimental opinion when it comes to Portugal), for Spain to consider a European exit calls into question the whole euro zone project.

Will European (read German) voters agree to large bailouts of Spain? And large they would need to be. Can the banks and the ECB live with even a small debt haircut or payment holiday of Spanish debt? That is one of the more intriguing games of international negotiations being played today, far more interesting than Greece ever was. The conclusion to Greece was easily seen in advance. It is not clear what happens with Spain. Can Merkel get the German public to go along? Will she willingly buck her voters if it appears they won't? Will Rajoy hold his ground in the face of the costs of either default or exit? Once you start the default game, you had better cut enough to get to sustainability for some time into the future, unless you get ECB agreement to buy future bonds, because the private bond market will disappear.

We are once again to a point in Europe where there are no good choices, only very bad ones. But this time it is with a country that actually makes a difference. (No slight intended to Greece, but you are just small.) Spain has no good way to cut its deficit without things getting worse. But Europe must be willing to then fund Spanish debt, even if "only" through more LTRO actions by the ECB.

This is a topic we will sadly be revisiting on many occasions. Stay tuned.

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